nti-avoidance measuresdocs.manupatra.in/newsline/articles/upload/c8034670-1e8e-4e9d-a… · vol....

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ANTI-AVOIDANCE MEASURES

T.P. Ostwal* and Vikram Vijayaraghavan

. TAX AVOIDANCE: AN INTRODUCTION ...................................................................... 61A. Tax Avoidance v. Tax Evasion ................................................................... 61B. Tax Avoidance Techniques – General Theory ............................................. 62

II. SOURCES OF ANTI-AVOIDANCE MEASURES............................................................... 63A. Introduction ............................................................................................... 63B. Judicial Anti-Avoidance Measures .............................................................. 63

(i) The “Business Purpose” Rule ...................................................... 64(ii) “Substance v. Form”..................................................................... 64

a. Legal v. Economic Substance ............................................. 64b. Sham Transactions ............................................................. 67c. Doctrine of the Label (“Wrong Characterization”) ....... 67d. Step-transaction Doctrine ................................................. 68e. Piercing the Corporate Veil ............................................... 69

(iii) Civil Doctrines .............................................................................. 73a. Abuse of Right (“Abus De Droit”) .................................... 73b. Abuse of Law (“Fraus Legis”) ........................................... 73c. Doctrine of Simulation ....................................................... 73

C. Legislative Anti-avoidance Measures .......................................................... 73(i) SAAR & GAAR .............................................................................. 73

a. What is the Rationale Behind GAAR? ............................. 73b. SAAR .................................................................................... 75c. Treaty Anti-avoidance Provisions ................................... 76

D. Administrative Anti-avoidance Measures .................................................... 77III. ANTI-AVOIDANCE MEASURES - WORLDWIDE SURVEY ............................................ 77IV. TAX AVOIDANCE - TECHNIQUES & COUNTER MEASURES ......................................... 81

* Senior Partner of M/s. Ostwal Desai & Kothari; Member of the Technical AdvisoryGroup (E-Commerce) of OECD Paris.

Published in Articles section of www.manupatra.com

National Law School of India ReviewVol. 22(2) 2010

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A. Tax Avoidance Technique #1 – Treaty Shopping ....................................... 81(i) Treaty Shopping Structures ........................................................ 82

a. Direct Conduits ................................................................... 82b. Stepping Stone Conduit ..................................................... 82c. Other Structures ................................................................. 83

(ii) Approaches Against Treaty Shopping ...................................... 84(iii) Treaty Shopping and the

OECD Model’s Beneficial Ownership ......................................... 84(iv) Treaty Shopping & Limitation on Benefit (Lob) Clauses ........ 85(v) Treaty Shopping & India ............................................................. 85

B. Tax Avoidance Technique #2 – Controlled Foreign Corporation .................. 86(i) Locational/Designated Jurisdictional Approach ..................... 87(ii) Transactional Approach .............................................................. 87

C. Tax Avoidance Technique #3 – Thin Capitalization .................................... 87(i) Arm’s-length Approach ............................................................... 88(ii) Hidden Profit Distribution .......................................................... 89(iii) “No Rules” Approach .................................................................. 89(iv) Fixed Ratio Approach .................................................................. 89

D. Tax Avoidance Technique #4 – Transfer Pricing Manipulation ................... 89E. Tax Avoidance Technique #5 – Transfer Of Residence ................................ 91F. Tax Avoidance Technique #6 – Branch Entities .......................................... 92G. Tax Avoidance Technique #7 – Tax Havens ............................................... 92

V. INTERESTING LEGAL QUESTIONS WITH ANTI-AVOIDANCE ........................................ 93VI. INDIAN DTC: PROPOSED GAAR ........................................................................... 96VII. INDIAN ANTI-AVOIDANCE & THE VODAFONE CASE ................................................ 98

A. Why Study the Vodafone Case? ................................................................ 98B. Background of Vodafone Case .................................................................... 99C. Overview of the Vodafone Case & Issues Raised by the Revenue ............... 99D. Legal Process Overview & Current Status .................................................. 100E. Facts of the Vodafone Case ......................................................................... 100F. Legal Issues Being Debated ........................................................................ 101G. Bombay High Court Ruling ....................................................................... 101H. Supreme Court – Special Leave Petition ...................................................... 101I. Conclusion ............................................................................................... 102

VIII. CONCLUSION ............................................................................................... 102IX. ACKNOWLEDGEMENTS ........................................................................................... 103


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I. TAX AVOIDANCE: AN INTRODUCTION

A. Tax Avoidance v. Tax EvasionTax avoidance has various definitions in legal rulings and academic

literature:-

a) Justice Reddy1 calls it the “art of dodging tax without breaking the law”;

b) Black’s Law Dictionary states that tax avoidance is the “minimization ofone’s tax liability by taking advantage of legally available tax planningopportunities”;

c) The Organization for Economic Co-operation & Development (OECD), terms“tax avoidance as an arrangement of a taxpayer’s affairs that is intended toreduce his liability and that although the arrangement could be strictlylegal is usually in contradiction with the intent of the law it purports tofollow”;2

d) The European Court of Justice (ECJ) views tax avoidance as “artificialarrangements aimed at circumventing law”;

e) The Carter Commission Report (Canada, 1966) states that tax avoidance is“every attempt by legal means to reduce tax liability which wouldotherwise be incurred by taking advantage of some provision or lack ofprovision in the law”;3

f) The landmark Helvering v. Gregory4 judgment says “any one may arrangehis affairs that his taxes shall be as low as possible; he is not bound tochoose that pattern which will best pay the Treasury; there is not even apatriotic duty to increase one’s taxes.”

The common theme amongst all the definitions of tax avoidance is that it isa “grey area” of exploiting, albeit legally, the tax laws of countries to maximumbenefit. There is often a thin line between acceptable tax avoidance, also knownas tax planning and unacceptable tax avoidance.

1 McDowell v. Commercial Tax Officer, (1985) 154 ITR 148 (Supreme Court of India)[hereinafter “McDowell”].

2 Glossary of Tax Terms, http://www.oecd.org/document/29/0,3343,en_2649_34897_33933853_1_1_1_1,00&&en-USS_01DBC.html.

3 Royal Commission on Taxation (Carter Commission), 1966, Canada.4 Helvering v. Gregory, 69 F.2d. 809 (2nd Cir. 1934).

Anti-Avoidance Measures



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Tax evasion on the other hand is the “unlawful escaping of tax liabilities.”5

A distinction has to be made between tax avoidance and tax evasion; thereis no thin line but a gulf between the two. The latter is clearly illegal; the formeris legal. Another way to look at it is that tax avoidance is a breach of socialcontract whereas tax evasion is a crime.

B. Tax Avoidance Techniques – General Theory

There are four basic tax avoidance techniques practiced,6 though numerousvariations and subtleties exist:

a) Deferred payment of tax liability

b) Re-characterization of an item or income or expense to tax at a lower or nil rate

c) Permanent elimination of tax liability

d) Shifting of income from a high-taxed to a low-taxed person

In practice these techniques are carried out using the following methods:

a) Use of tax Treaties for related-party transactions (i.e., “Treaty Shopping”)

b) Use of international tax shelters through artificial intermediary companies(i.e., “CFC”)

c) Excessive use of debt over equity (i.e., “Thin capitalization”)

d) Non-arm’s length transactions (i.e., “Transfer Pricing manipulation”)

e) Transfer of residence

f) Branch entities

g) Use of Tax Havens

The bottom line is that all tax avoidance techniques take advantage ofinconsistencies and discontinuities in the tax systems through various taxarbitrage techniques. We will look at how these techniques are used in moredetail while discussing their counter-measures in later sections of this paper.

5 Royal Commission on Taxation of Profits and Income, UK, 1955 [hereinafter“Radcliffe Commission”].

6 R. Rohatgi, Anti-Avoidance Measures, in BASIC INTERNATIONAL TAXATION VOLUME II: PRACTICEOF INTERNATIONAL TAXATION 141 (2000).


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II. SOURCES OF ANTI-AVOIDANCE MEASURES

A. Introduction

Given these tax avoidance techniques, it is illustrative to see howgovernments around the world react to this problem.

a) Legislative solutions: Most governments seem to rely on anti-avoidancestatutes which are passed by their legislatures. Such legislations can bebroken down into two categories and their distinction is very importantas we will see in later sections of this paper:

1. Specific anti-avoidance rules targeted at specific tax avoidancemeasures [hereinafter “SAAR”]

2. General anti-avoidance rules which are, as the name suggests a catch-call system for tax avoidance [hereinafter “GAAR”]

3. Bilateral measures are also pursued through treaties or DoubleTaxation Agreements [hereinafter “DTAAs”]

i. This can be done via various clauses inserted in them. Examplesof this include the “Beneficial Ownership” and “Limitation onBenefit” clauses one finds in many Treaties.

ii. The treaties may have specific anti-treaty shopping rules

iii. The use of the Articles pertaining to Exchange of Informationin Treaties are also used to counter tax avoidance

b) Judicial solutions: The Courts across the world have been instrumental inevolving and developing various judicial doctrines to curb tax avoidance.

c) Administrative solutions: To figure out tax avoidance has taken place and toget information on such practice is paramount; administrative measures are auseful tool for governments to both curb and detect tax avoidance practice.

B. Judicial anti-avoidance measures

The Courts may take either a literal, i.e., strict view or purposive viewtowards statutory interpretation. Dozens of Courts the world over have playedan important role in developing SAAR and GAAR principles and laws. The twoguiding principles7 in judicial anti-avoidance are:

7 Frederik Zimmer, Form and Substance in Tax Law (IFA Cahiers, Vol 87A, GeneralReport 2002); See also supra note 7; IFA Online, http://www.ifa.nl.




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a) Business purpose rule (motive test)

b) Substance over form rule (artificiality test)

(i) The “Business Purpose” rule

The “business purpose rule” is simple; it says that a transaction must serve abusiness purpose, i.e., commercial justification, other than tax avoidance. Mere taxadvantage cannot be the sole or main business purpose. In the landmark judgmentGregory v. Helvering8 the U.S. Supreme Court held that a corporate reorganizationunder the law solely for tax purposes did not qualify for tax benefits.

It should be mentioned that business purpose is seldom defined in thestatutes; Courts simply adopt a common-sense view. There are several dozenU.K. rulings which have attempted to define “business purpose”.

There are some interesting questions one can ask when it comes to businesspurpose; should the business purpose always be financial? Is defence from atakeover a justified business purpose? Another question is, is the motive distinctfrom purpose; does the purpose refer to the ultimate objective or aim or does itmean the subjective motive of the taxpayer? The answer to these questions is leftas a puzzle for the reader to solve; suffice to say one could refer to Inland RevenueCommissioner v. Brebner9 and Mallelieu v. Drummond.10

(ii) “Substance v. Form”

The substance versus form principle is wider in scope than the businesspurpose rule; the 1987 OECD report defines it as “the prevalence of economic orsocial reality over the literal wording of legal provisions.”

Substance versus form makes for fascinating debate; when does one stopliterally interpreting and start piercing the veil? There is no easy answer for this.Whatever be the case, it would be wise for any legal student or practitioner tounderstand the various faces of “substance v. form” as listed below:

a) Legal v. Economic Substance

This applies to situations where due to the legal form used for thetransaction a taxpayer has the real economic power over the taxable incomewithout the tax liability.

8 Helvering v. Gregory, 69 F.2d 809 (2nd Cir. 1934).9 Inland Revenue Commissioner v. Brebner, [1967] 2 A.C. 182 (H.L.) (U.K.).1 0 Mallelieu v. Drummond, [1983] S.T.C. 665 (H.L.) (U.K.).


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A famous case in this regard is the Duke of Westminster case.11 In this casethe taxpayer executed tax-deductible deeds of covenants to pay selectedemployees without affecting their non-deductible wage entitlements. Underseparate non-contractual agreements with the employees, it was assumedthat they would not expect to be paid their existing wages but be contentwith payment under the covenant plus such additional amount as requiredto increase their income to their current salary. The House of Lords held thatthey must be regarded as covenanted payments and that they were entitledto deduct them. In short, the Court accepted the legal form of covenantedpayments although they could be treated in substance as the economicequivalent of wage.

Another important case regarding economic substance is Aiken Industriesv. Commissioner.12 The short summary of this case is as follows: MechanicalProducts Inc. (Aiken’s predecessor) raised debt from an Ecuadorian corporationand issued promissory notes; the Ecuadorian corporation then exchanged thesepromissory notes for new promissory notes issued by Industrias, a Hondurancompany. Aiken repaid the debt and interest to Industrias, which in turnrepaid its debt along with interest to the Ecuadorian corporation. Revenuecontended that the entire structure was devised solely to avoid tax sinceinterest payments to Industrias would not be eligible to tax withholding underUS-Honduras Treaty (DTAA). The Court agreed with Revenue and held thatAiken, the successor of Mechanical Products, was liable for withholding taxeson interest paid.

One more landmark case relating to economic substance is Northern IndianaPublic Service Company v. Commissioner [hereinafter “Northern Indiana Public ServiceCompany”].13 The short summary is as follows. Northern Indiana USA intendedto raise debt in Europe where interest rates are relatively lower; for this asubsidiary was set up in Netherlands to borrow from European bond holders.The terms and two notes were different and there was a small spread at theDutch subsidiary level. Revenue contended that Dutch subsidiary was set upto avoid tax. The Court disagreed with Revenue saying financing was not withrelated parties and Dutch subsidiary had profit motive from the start.

1 1 Duke of Westminster v. Commissioner of Inland Revenue, [1936] 1 A.C. 19 (H.L.)(U.K.).

1 2 Aiken Industries v. Commissioner, 56 T.C. 925 (1971) (U.K.).1 3 Northern Indiana Public Service Co v. Commissioner, 105 T.C. 341 (1991).




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Figure 1: Northern Indiana Public Service Company case

A very recent case on this principle is that of Jade Trading v. United States.14 Thiscase involved a tax shelter designed to produce large, artificial, i.e., noneconomiclosses for tax purposes. The tax shelter involved 4 steps:

- Investment in Foreign Currency

- Contribution to a Partnership

- Partnership Investments

- Termination of Partnership Interests

The overall scheme:

- Investor first simultaneously purchased a European-style call option andsold a European-style call option.

- The investor next contributed the purchased and sold options to apartnership.

1 4 Jade Trading LLC v. United States, United States Court of Appeals for the FederalCircuit, 2008-5045 dated Mar. 23, 2010.


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- The investor eventually exited the partnership, received an asset with aclaimed high-basis and low-value and then sold that asset to generate atax-loss.

A tax loss was anticipated because, at the time of the facts giving rise to thecase, an investor’s basis in a partnership was ordinarily not decreased by theamount of a contingent liability contributed to or assessed by a partnership. TheIRS held that the Jade partnership should be disregarded and all transactionsengaged in by Jade should be treated as being engaged in directly by the purportedpartners. Both the Court of Federal Claims and the United States Appeals for theFederal Circuit upheld that the contribution of the spread transaction, via eurocall options, to Jade was a transaction that lacked economic substance and affirmedthe denial of Jade’s petition (Emphasis Supplied).

b) Sham Transactions

In a sham transaction, they (the ‘tax avoiders’) give effect to a transaction,which they do not carry out, or do not intend to carry out or is a cover up foranother transaction or relationship. A sham transaction essentially conceals thetrue nature or reality of a transaction that exists in form only. In short, the legalform is retained but the underlying substance is not genuine in law.

A landmark judgment regarding sham transactions is the Knetsch case.15 Inthis case, the taxpayer borrowed money at 3.5% to make a return of 2.5% from aninvestment in annuity issued by insurance company. Investment income wastaxed at lower capital gains rate and the interest payments were fully deductiblefor tax purposes. The US Supreme Court treated the transaction as a sham anddisallowed the interest paid on the loan. It was held that there was “nothing ofsubstance to be realized beyond a tax deduction.”

c) Doctrine of the Label (“wrong characterization”)

In this method, parties use incorrect labels to classify or characterize atransaction or relationship for tax purposes.

A relevant case in this regard is the Ridge Securities case,16 where the Courtrejected a loan with interest at over 400% per annum as a loan transaction.

1 5 Knetsch v. United States, 364 U.S. 361 (1960).1 6 Ridge Securities v. IRC, (1962) 44 T.C. 373 (Ch.D) (U.K.).




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In Council of India case,17 the Court rejected a purchase consideration describedas an annuity payable over 47 years.

In the Vestey case18 the taxpayer had agreed to sell his shares at aconsideration payable over 125 yearly instalments and treated the entire priceas a capital receipt.

d) Step-transaction doctrine

Certain countries (like USA, UK, Japan and Canada) regard a series of connectedtransactions as a single transaction under the “substance v. form” principle.

In a “step transaction”, the intermediate steps in a chain of preordained,even if bona fide, transactions may be disregarded and several related transactionsmay be treated as a single composite transaction. Alternatively, a singletransaction may be broken into distinct steps too to determine its tax acceptance.

It was observed in McDonald’s case19 that “purely formal distinctions cannotobscure the substance of the transaction.”

An important case law in step-transaction is the W.T. Ramsay case20 wherethe taxpayer made a large capital gain on the sale of a farm. To offset this, heentered into a series of separate share and loan transactions which generatedboth a non-taxable gain and fully allowable loss. The multi-step transactions asa whole were circular and self-cancelling. The taxpayer hence began and endedin the same financial position and still claimed a tax loss. The House of Lordsdisallowed the loss as fiscal nullity since the taxpayer had made no real financialloss and thereby established the “Ramsay doctrine” (doctrine of fiscal nullity).

Another case related to step transaction is Gregory v. Helvering21 where thetaxpayer attempted to avoid dividend tax through a tax free corporate reorganization.

A much referred judgment related to step transaction is the famous Furnissv. Dawson case.22

1 7 Council of India v. Scobie, 4 T.C. 618 (UK).1 8 Vestey v. IRC, (1949) 40 T.C. 112 (Ch.D) (U.K.).1 9 Mcdonald’s Restaurant of Illinois v. Commissioner, 688 F.2d 520 (7th Cir. 1982).2 0 W.T.Ramsay Limited v. Inland Revenue Commissioner, (1981) 54 T.C. 101 (H.L.) (U.K.)2 1 Helvering v. Gregory, 69 F.2nd 809 (2nd Cir. 1934).2 2 Furniss (Inspector of Taxes) v. Dawson D.E.R., [1984] A.C. 474 (H.L.) (U.K.).


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Figure 2: Furniss v. Dawson case overview

The short summary of this case is that Dawson decided to sell shares to WoodBastow for £152,000. There was a deferral of capital gains by the following steps-

- Incorporation of Manx, a company

- Contribution of shares worth £152,000 in return for shares of Manx (tax-free transaction)

- Sale of shares by Manx to Wood Bastow for £152,000

The Court applied the Ramsey doctrine and imposed direct tax on sale &disallowed capital gains deferral.

It is interesting to note that the Courts in England have shown proclivitytowards moving away from the Ramsey doctrine in subsequent decisions likeCraven v. White,23 Macniven v. Westmoreland Investments Ltd.,24 Barclays Mercantile BusinessFinance Ltd. v. Mawson,25 Inland Revenue Commissioner v. Scottish Provident Institution,26

etc. The interested reader may take this up for further research.

e) Piercing the Corporate Veil

The piercing of the corporate veil is one of the most debated topics today incorporate circles.

2 3 Craven v. White, (1988) 3 WLR 423 (H.L.) (U.K.).2 4 MacNiven v. Westmoreland Investments, [2001] S.T.C. 237 (H.L.) (U.K.).2 5 Barclays Mercantile Business Finance Ltd v. Mawson, [2005] S.T.C. 1 (H.L.) (U.K.).2 6 Inland Revenue Commissioner v. Scottish Provident Institution, [2005] S.T.C. 15

(H.L.) (U.K.).




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The classic case for veil piercing is Salomon v. Salomon27 where Salomonconverted the business to a limited liability corporation when it was doing well.The business then floundered and went into liquidation. The question was ‘whatwas the true intent behind the conversion of the business?’ The House of Lordsruled that the company had been validly formed and in the famous words ofLord Macnaghten, “The company is at law a different person altogether from thesubscribers to the memorandum of association…” On this basis, the court upheldthe conversion of business as bona fide.

Another classic in common law veil piercing is Adam v. Cape Industries.28

Synopsis of the case is that Cape was a large MNC based in England and in theasbestos industry. NAAC (Cape’s North-American subsidiary) had damagesclaimed by its employees in Texas due to asbestos-related illnesses. NAAC wasliquidated and activities continued by new entity called CPC. Fact is that CPCwas set up with financial support from Cape and operated in same premiseswith same employees as NAAC. However CPC was controlled via a Luxembourgagency of Cape called AMC (i.e. Cape AMC CPC). When fresh damages wereclaimed by employees, Cape refused to appear before American Courts saying ithad no interests in America anymore and that AMC (its agency) came betweenCPC and Cape. The Courts sided on the side of Cape Industries saying the corporateveil cannot be lifted. However in coming to their decision, most importantly, theCourts went into an analysis on the three possible grounds for piercing, i.e.,fraud, agency and the single economic unit theory.

An interesting Indian case related to corporate veil piercing in CompanyLaw is the Wood Polymer case.29 In this case, the company asked for grant of sanctionof scheme of amalgamation under section 391(2) of the Companies Act, 1956. Thescheme of amalgamation involved:

a) Amalgamation of the transferor-company (Bengal Hotels Pvt. Ltd., a privatelimited company) with the transferee-company (Wood Polymer, a publiclimited company) along with the dissolution of transferor-companywithout winding up.

b) According to the official liquidator’s report, the transferor-company (BengalHotels) was merely created to facilitate the transfer of “Avenue House”

2 7 Salomon v. Salomon & Co., [1897] A.C. 22 (H.L.) (U.K.).2 8 Adams v. Cape Industries plc, [1990] Ch. 433 (C.A.) (U.K.).2 9 In re: Wood Polymer Limited (1977), 109 ITR 177 (Guj.) (High Court of Gujarat).


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immovable property (belonging to the transferor-company’s parent, DOCLtd.) to the transferee-company (Wood Polymer) so as to avoid the paymentof capital gains tax, which would otherwise have been payable undersection 45 of the Income Tax Act, 1961.

c) In order to avoid this capital gains tax, the transferor-company was floatedand transferor-company availed of the benefit enacted in section 47 of theIncome Tax Act.

The Court looked at relevant sections of the Companies Act and held thatthe Court is not merely a rubber stamp in scrutinizing a scheme of amalgamation.The following questions were also examined in detail by the Court:

a) What was the legislative intent in introducing the second proviso to section394 of the Companies Act?

b) What is the ambit, scope and outer periphery of the concept of ‘publicinterest’ as envisaged in the second proviso?

c) Is the disclosed purpose put forth by the companies who have moved theCourt for sanction of merger/amalgamation, relevant consideration for theCourt or could the Court probe and go behind the apparent purpose and ascertain thereal purpose and take into consideration that purpose, so as to reach aconclusion that for such a purpose the Court would not permit its processto be utilized if the purpose is shown to be one which is opposed to publicinterest? (Emphasis Supplied)

d) If, except for the tax benefit, no other purpose for merger/amalgamation is disclosed oron probing, tax avoidance appears to be the major and only purpose for thescheme, could it not be said that the purpose is such that Court should notsanction the scheme on the ground that it is opposed to public interest?(Emphasis Supplied)

e) Should the Court by its process facilitate avoidance of tax, even if it can besaid that avoidance is legal and cannot be styled as tax evasion?

The Gujarat High Court looked at various decisions of the Indian and EnglishCourts and came to a decision that the said scheme of amalgamation could not besanctioned. It held that:

The scheme of amalgamation must have some purpose or object toachieve...the purpose and the only purpose appears to be to acquirecapital asset of DOC Ltd. through intermediary transferor-




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company…it can never be said that the affairs of the transferor-company sought to be amalgamated, created for the sole purpose offacilitating transfer of capital asset, through its medium, have notbeen carried out in a manner prejudicial to public interest…the Courtwill not lend its name its assistance to defeat public interest, namely tax provision.…It must be confessed that it is open to a party so as to arrange itsaffairs so as to reduce tax liability…but it must be within the power of theparty to arrange its affairs. If the party seeks the assistance of the Court to reduceits tax liability the Court should be the last instrument to grant such assistanceor judicial process to defeat a tax liability…here the tax cannot be avoidedunless the Court lends its assistance, namely, by sanctioning thescheme of amalgamation. In other words, the judicial process is usedor polluted to defeat the tax by forming an appropriate device orsubterfuge. Such a situation can never be said to be in the publicinterest and on this ground the Court would not sanction the schemeof amalgamation. (Emphasis Supplied)

The key question is “when can the corporate veil be lifted?” The answerfrom judicial rulings seems to be: when the device of incorporation is used for anillegal, improper or fraudulent purpose or when mandated by specific provisionsof law or contract.

Empirical data on corporate veil piercing is available, as far as we know,only in the USA. A study by Thompson30 showed 1,583 veil piercing cases before1985 with 40% cases resulting in veil piercing. This should again be rich fodderfor the aspiring legal researcher!

India’s stand in corporate veil piercing has been that the Courts typicallywill not pierce corporate veil in tax cases. However with some recent decisions itfeels like the tide is changing; for example, refer Ansaldo Energia SPA31 case whereASPL India was “pierced” and 4 contracts were treated as a composite contract.The recent Vodafone32 case is discussed in more detail in a later section but there issome apprehension as to whether it will represent a new frontier in corporateveil piercing by Indian courts.

3 0 Robert B.Thompson, Piercing the Corporate Veil, an Empirical Study, 76 CORNELL L. REV.1036 (1991).

3 1 Ansaldo Energia SPA v. ITAT, Tax Case No. 1303 of 2007, Jan. 12, 2009 (Mad.) (HighCourt of Madras).

3 2 Vodafone International Holdings BV v. Union of India, (2008) 175 Taxmann 399(Bom.) (High Court of Bombay).


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(iii) Civil doctrines

Courts in many countries have tended to apply civil law doctrines to controlgeneral tax abuse. The main civil law doctrines used are:

a) Abuse of Right (“Abus de Droit”)

Several jurisdictions apply the form and purpose rules of abuse of right doctrineunder Civil Law (Example: Austria, France etc). The abuse of right is themanipulation of the intention or spirit of the law. Courts typically disregardthe legal form where transactions are solely undertaken to avoid tax.

b) Abuse of Law (“Fraus Legis”)

Many civil law countries apply the Roman law doctrine of fraus legis. Agood example is The Netherlands. Fraus legis resembles the business purposerule. Under this, the Court disregards any transaction entered for taxavoidance purposes and substitutes it by a “normal” transaction.

c) Doctrine of Simulation

Certain civil law countries, like Belgium, apply this doctrine to ensure‘substance over form’. It arises when there is no real transaction or there isa hidden real transaction or relationship. In such cases tax authorities candisregard the simulated transaction and replace it with the real one. Thisprinciple resembles the sham transaction or doctrine of wrong label.Examples of simulation include sale and leaseback transactions where therespective rights and obligations of the parties are not transferred insubstance.

C. Legislative Anti-Avoidance Measures

(i) SAAR & GAAR

Two kinds of statutory anti-avoidance measures exist: GAAR and SAAR.The GAAR as its name implies is a set of general anti-avoidance rules; think of itas a “catch-all” for tax avoidance. The SAAR is a specific anti-avoidance rule andis targeted at curbing a specific avoidance practice or technique.

a. What is the rationale behind GAAR?

It is easy to understand the need for SAARs and their source of evolution –typically by judicial rulings or as a reaction to a commonly used avoidance




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technique in the marketplace. However what is the rationale for having GAARprovisions? Justice Murphy said it best in Federal Commissioner of Taxation v. Hancock,“The resource of ingenious minds to avoid revenue laws has always provedinexhaustible and for that reason it is neither possible nor safe to say in advancewhat must be found….” 33

The advantages of GAAR are that given tax avoidance schemes are becomingincreasingly complex and tough to anticipate via SAARs, governments acrossthe world want to stop losing what they perceive as billions of dollars of revenueand so implement GAAR provisions as a ‘catch-all’ scheme for tax avoidance ingeneral.

On the downside, the real problem with GAAR is that it can end uppromoting uncertainty. It is a good time to recollect what Adam Smith said abouttaxes – that certainty is valued more than fairness and simplicity. The GAARmay also be construed as contrary to the rule of law principle, i.e., laws are meantto be reasonably certain or predictable.

In fact, the Canadian GAAR when introduced was challenged asunconstitutional on these grounds but the Canadian Supreme Court held thatbroad, purposive interpretation of GAAR is appropriate; refer Canada TrustcoMortgage case.34

A GAAR is basically an attempt to strike down avoidance that is notunderstood at the time of drafting. The difficulty with having such a broadscheme has been heavily debated in various countries as and when they grappledwith the thought of introducing GAAR. For example the Taxation ReviewCommittee, 1975, Australia debated:

In framing legislation sufficiently all-embracing to deter taxavoidance, there is always the danger of penalizing those who havea genuine reason for entering into a bona fide transaction, which, ifcarried out by others, has the objective that ought to be prevented.There is frequently such a very fine line to be drawn between thetransaction which offends and the one which merits nocondemnation.

3 3 Federal Commissioner of Taxation v. Hancock, (1961) 8 ATR 328, 333.3 4 Canada Trustco Mortgage Co v. Canada, 2005 2 S.C.R. 601 (Supreme Court of

Canada).


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It must be noted that developed countries like USA, UK do not have statutoryGAAR. Rather, judicial doctrines combined with SAARs (prospective &retrospective) and other administrative measures seem to be the right mix forthem.

A really interesting question (yet another prime material for the legal minds)is whether GAAR really does slow tax avoidance; in fact, can there be an oppositeeffect? Waincymer’s research lead to his commentary on how when BarwickHigh Court (Australia) strictly interpreted GAAR, it lead to an increase in thelevel of tax avoidance in Australia! He states:

One intuitive lesson to learn from the Australian experience is thatwhen tax avoidance became virtually sanctioned by the High Courtin the 1970’s, supermarket style off-the-shelf tax avoidance packagesreached epidemic proportions. Having the Chief Justice of the HighCourt propound taxpayer rights would surely be a powerfulrationalizing factor for taxpayers and advisers.

In a similar vein, noted Canadian tax expert Arnold considers the Canadianexperience to demonstrate GAAR will only slow avoidance when interpretedpurposively and when narrowly interpreted it may actually lead to more taxavoidance. He points out that when the Canadian Supreme Court in one of itsrulings endorsed a purposive approach of the provisions, Revenue Canadaresponded by interpreting provisions literally. Further Revenue Canadaannounced it would issue advanced tax rulings and issued a Declaration ofTaxpayer Rights which provided that taxpayers “have a right to arrange affairsin order to pay the minimum tax required by law.” According to Arnold, responseof taxpayers and their advisers to the approach of Revenue Canada was to engagein aggressive tax planning which ultimately lead to shortfalls in collections oftaxes.

(b) SAAR

There are many examples of SAARs around the world enacted by variouscountries. Some examples are thin capitalization rules and CFC (controlled foreigncorporation) rules which are passed to curb specific tax avoidance techniques;suffice to say these are elaborated upon in the later section on tax avoidance andcounter measures.

Typically SAARs are prospective; however they can retrospective too andthe increasing use of retrospective SAARs is a cause of concern for taxpayers.




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(c) Treaty anti-avoidance provisions

Tax treaties (DTAAs) have evolved over time to include a plethora of anti-avoidance provisions in them. Some of the examples are:

- Arm’s-length definition for related party transactions (Article 9) to defeattransfer pricing manipulation,

- Limitation on Benefit (LOB) clauses to counter treaty shopping,

- The concept of “beneficial ownership” applied to Interests, Dividends &Royalties (Article 10, 11 and 12) and

- Specific provisions against transactions with tax havens.

All the above measures are dealt with in later sections of this paper whentax avoidance techniques and counter measures are elaborately discussed. Hence,we do not wish to duplicate the same content here but wish to point out that taxtreaties are evolving documents and are good weapons in the hands of bothGovernments (in case of bilateral treaties) to sit down and come up with waysand means to curb tax avoidance. It must be noted that the continuingcontribution by academic and legal experts at OECD (and the UN), whose ModelConventions35 most countries follow is critical in this regard.

One anti-avoidance measure which we need to mention and which is notdiscussed elsewhere in this paper is the Exchange of Information Articles in thetreaties. Article 26 of the OECD Model Convention is a widely accepted legal basisfor bilateral exchange of information for tax purposes. It creates an obligation toexchange information that is foreseeably relevant to correct application of a taxconvention as well as for the purposes of administration and enforcement ofdomestic laws of the Contracting States. This Article serves as an important toolto detect and gather information on tax avoidance.

A related development is that of Taxation Information Exchange Agreements.The OECD has developed a process that enables certain non-OECD offshorefinancial centre jurisdictions to commit to eliminating harmful international taxavoidance and evasion practices. These jurisdictions can do this by committingto a program of exchange of information agreements with OECD member countries.

3 5 OECD Model Tax Convention on Income and on Capital, January 2003; CanadaTrustco Mortgage Co v. Canada, 2005 2 S.C.R. 601 (Supreme Court of Canada).


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The OECD member countries and committed jurisdictions are collectively knownas ‘participating partners’. There are a number of non-OECD offshore financialcentre jurisdictions committed to such taxation information exchange agreements(TIEA). These agreements aim to establish effective information exchange andimprove transparency of taxpayers’ financial arrangements/transactions for taxpurposes and also provide important momentum to achieve the aims of the OECD’sharmful tax practices initiative.

D. Administrative anti-avoidance measures

Administrative measures are mainly to ensure compliance and/or to detecttax avoidance. They are usually carried out in the following ways:

a) By use of investigative powers when a GAAR exists

b) By use of administrative powers to build a common law avoidance case, injurisdictions where no GAAR exists (example: New South Wales, Australia)

c) By use of taxpayer alerts & rulings – these typically discuss how anadministration intends to apply statutory GAAR

d) By appointing GAAR panels to decide GAAR issues.

Exchange controls & tax clearances are also used by countries as anti-avoidance measures; these transactions are subject to either prior governmentapprovals or to post-transaction reporting of income or capital flows. For example,Canada requires its residents to report all foreign investments in excess of 100,000Canadian dollars to tax authorities. Many countries, especially developing, stillhave partial or full exchange controls on current and/or capital account thatmonitor tax issues on cross-border transactions.

III. ANTI-AVOIDANCE – A WORLD WIDE SURVEY

It is illuminating to see the anti-avoidance measures used in variouscountries around the world.36 It seems that a combination of the varioustechniques discussed in previous sections, have been used to combat tax avoidance.One feels it would make an interesting study as to possible reasons for eachcountry to choose to evolve a particular set of anti-avoidance measures.

3 6 Supra note 7, at 153.




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Country Short summary of anti-avoidance measures

Australia • GAAR since 1981 Income Tax Act.

• Courts have shifted over the years to purposive interpretationfrom a literal approach.

Austria • Taxpayer is free to arrange affairs but broad limitations areplaced under the GAAR.

• However, tax avoidance must be main or only motive of taxpayerarrangements and strict burden of proof on tax authorities; it isconsidered irrelevant that arrangements are “unusual”.

Belgium • Traditionally applied civil law of simulation (also known asBrepols doctrine).

• Normally adopts strict, literal interpretation, i.e., legal formover substance is usually considered.

• GAAR was adopted in 1993, advanced rulings can beobtained for GAAR.

Denmark • Applies substance over form under a “correct recipient ofincome” principle.

Canada • In Stubart (1984), the Supreme Court expressly rejected thebusiness purpose test and reaffirmed the Duke of Westminsterdoctrine.

• Enacted a GAAR in 1988; specific criteria for applying GAARset out by the Courts and benefit of doubt given to taxpayer.

France • Tax avoidance (evasion fiscale) lies between tax evasion (fraudefiscale) and tax planning (habilete fiscale).

• Abuse of rights (abus de droit) doctrine based on decisions ofConseil d’Etat and Cour de Cassation.

• Two tests of tax avoidance laid down:

• Sole purpose to avoid tax (fraude a la loi) or

• transaction is fictitious (simulation)

• Also apply doctrine of “abnormal management act” (actenormal de gestion).


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• Generally Courts favour the taxpayer; it is not unlawful tochoose the most economical, legal and financial way from atax viewpoint.

Germany • Contains GAAR in tax code (AO). Legal structures can bedisregarded under “abuse of form and legal structures”provision.

• Courts apply substance over form; use the principle ofanalogy and teleological reduction in their decisions. Advancerulings are given.

• Germany has one of the highest numbers of anti-avoidancerelated cases.

India • No GAAR yet. Domestic law has SAAR provisions (e.g.,sections 37(1) and 40A(2), Income Tax Act, 1961).

• Underlying principles implemented through judicial andadministrative decisions.

• Courts have favoured taxpayer historically and taken literalview. (Ref: Kulandagan Chettiar, R.M.Muthaiah and S.R.M Firmcases).

• Azadi Bachao Andolan was a landmark case which acceptedthat every man was entitled to arrange his own affairs as notto attract taxes (reaffirming Duke of Westminster principle anddistinguishing McDowell).

Israel • Specific measures to counteract tax planning involving foreignprofessional companies (FPC),

• Has a GAAR (section 86, Income Tax Ordinance).

Italy • Follows letter of law where form takes precedence oversubstance.

• Tax avoidance so far handled through statutory provisions(SAARs).

• Earlier efforts to introduce GAAR were unsuccessful.

Japan • Has authority to re-compute tax base of corporate incometax, amount of net loss and corporate tax payable.




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Netherlands • Dutch Law provides for a GAAR though Courts rely on frauslegis (abuse of law).

Portugal • GAAR introduced in 1999.

• Burden of proof remains with tax authorities to showprimary intention of tax avoidance.

Spain • Tax code allows taxation of transactions based on their realeconomic nature, irrespective of legal form.

• Civil Code has also codified the abuse of law principle – twospecial provisions namely fraus legis and simulation.

Sweden • Attempted several versions of GAAR. The Tax Avoidance Act,1995 was amended in 1998.

• Burden of proof lies with tax authorities and advance rulingsare given.

• Furthermore, law specifies that the GAAR can only be appliedunder a Court order by tax authorities.

Switzerland • Applies both business purpose and substance over formdoctrine under its law.

• In tax avoidance cases the tax authorities can substitute thecustomary construction for the transaction and taxaccordingly.

United • Does not have statutory GAAR.Kingdom

• Do not accept principle of abuse of rights as applied in civillaw jurisdictions (Ref: Chapman v. Honig).

• In principle, tax avoidance is legal and tax evasion illegal;transaction must not be unlawful and purpose/motive mustnot be affected by specific anti-avoidance provisions.

• U.K. Courts traditionally follow literal approach rather thanpurposive.

• Early U.K. decisions favour taxpayer (Ref: Duke of Westminister,Ayrshire Pullman Motor Service, etc.).


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• U.K. Courts have also taken a purposive approach in severallegal decisions: Ramsay case, Furniss v. Dawson, McGuckian case.

• U.K. Courts still maintain that role of Courts to legislate andlook-through only in blatantly artificial transactions (Ref:Craven v. White (1988)).

• Government primarily relies on SAAR and judicial decisions.No GAAR was enacted though in 1988 the Revenue publisheda consultative document but it was decided subsequentlynot to implement any GAAR.

United States • Does not have statutory GAAR.

• The Courts have evolved several judicial anti-avoidancedoctrines.

• Gregory v. Helvering (1935) held that any one may arrange theiraffairs that his taxes shall be as low as possible.

• Courts tend to apply substance over form (Ref: Aiken Industriesand Johansson v. USA).

• Similarly, transactions or series of transactions without abusiness purpose may be ignored.

IV. TAX AVOIDANCE TECHNIQUES & COUNTER MEASURES

A. Tax Avoidance Technique #1 – Treaty Shopping

The “abuse of tax treaties” is the use of tax treaties by persons the treatieswere not designed to benefit, in order to derive benefits that the treaty were notdesigned to give. Treaty shopping connotes a premeditated effort to take advantageof the international tax treaty network and a careful selection of the mostfavourable tax treaty for a specific purpose (refer to Rosenbloom H.D, Tax TreatyAbuse: Problems & Issues).




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(i) Treaty Shopping structures

There are a variety of treaty shopping structures. Some of them are:

a) Direct Conduits

A direct conduit works as shown in the diagram below. Resident of State Rexpects to derive dividends, interest or royalties sourced in another state (StateS). So it sets up entity in a third state (State C) that will receive dividends, interestand royalties in a more tax beneficial way than if income were paid directly fromState S to R. The tax advantage results from fact that tax treaty between S and Cprovides for more advantageous withholding tax rate in State S if paid to State Cresident than if paid to State R resident.

Figure 3: Direct conduit structure

b) Stepping stone conduit

A stepping stone conduit works as follows: Residents of State R establishcompany resident in State C where it is fully subject to tax on income derivedfrom S. However it pays high interest, royalties, service fees, commissions &


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other expenses to a second related foreign company (base company) set up in afourth state (State B) and controlled by shareholders of the conduit company.These payments are deductible in State C and are either not taxed or veryadvantageously taxed in State B because the company enjoys a preferential taxregime there.

Figure 4: Stepping Stone conduit structure

c) Other structures

There are other treaty shopping techniques in practice; examples aretriangular structures where a low or nil taxed branch of a company in a treatycountry receives income from a third country. Another approach is to use hybridentities that are characterized differently in the two Contracting States.Individuals can also treaty shop by transferring tax residence to another treatycountry, i.e., ‘emigration’ - also a form of treaty shopping. For instance, a residentof France owning an important shareholding in French company may emigrate




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to Belgium in view of later sale of shares because under Article 18 of Belgium-France tax treaty the right to tax the capital gain is conferred to Belgium butBelgium does not levy capital gains tax on individuals (except speculation).

In fact, the national policies of many countries favour treaty shopping. Sourcecountries may encourage (or at least, not discourage) it. Residence countries maypermit to develop overseas markets or improve competitiveness and/or limitsource taxation. For example, treaty shopping is encouraged in EU if it helps tobreak national boundaries and create a single market. Also, generally developingcountries may view treaty shopping as a tax incentive.

In other words treaty shopping, when it is beneficial may be tacitly approvedand when disadvantageous may be disapproved. For example, some of themhave revoked tax treaties in cases of circular situations when the income is sourcedin the same country where the shareholder is resident but the income passesthrough a company resident in another country for tax reasons, i.e., “roundtripping”. This has been considered abusive by India, Brazil, Indonesia, etc.

(ii) Approaches against Treaty Shopping37

a) Neutral measures by combining domestic and tax treaty provisions.Example: non-domiciled residents in U.K. may be entitled to treaty benefitson foreign income only when remitted.

b) Specific measures that deny benefits to entities which are not subject to taxin their state of residence.

c) Purpose-based measures that deny certain treaty benefits set up only forclaiming such benefits. Example is no tax refunds are given underNetherlands treaty with the U.K. in such cases.

d) Comprehensive measures imposed under domestic legislation or treaties.For example, Article 22, U.S. Model Treaty on Limitation on Benefits, 1996;Swiss Abuse Doctrine, 1962.

(iii) Treaty Shopping and the OECD Model’s “Beneficial Ownership”

The OECD Model Convention38 has long recognized the problems caused bytreaty shopping. The OECD Model Convention has the concept of “beneficial

3 7 Supra note 7, at 167-182.3 8 OECD Model Tax Convention on Income and on Capital, January 2003.


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owner” applied to Article 10 (dividends), Article 11 (interest) and Article 12(royalties). Beneficial ownership is not just legal but also economic. There havebeen various OECD reports over time which have constantly refined the approachto combat Treaty Shopping –

- OECD Report on Use of Conduit Companies (1987)

- Harmful Tax Competition (1988)

- Commentary Update 2003

(iv) Treaty Shopping & Limitation on Benefit (LOB) clauses

Generally these LOB clauses exclude resident companies from tax treatybenefits unless they have a sufficiently strong nexus to the contracting statewhere they claim residence.

Such provisions may limit benefits to companies which have a:

- Certain minimum level of local ownership (look-through approach)

- Deny benefits to companies which benefit from a privileged tax regime(exclusion approach)

- Deny benefits to companies which are not subject to tax in respect of incomein question (subject-to-tax approach)

- Deny benefits to companies which pay on more than a certain proportionof the income in tax deductible form (channel approach)

(v) Treaty Shopping & India

In the Azadi Bachao Andolan case,39 the Supreme Court held that there was noinherent anti-abuse rule in Indian tax treaties and hence it required specific LOBclause in the treaty itself for the denial of treaty rights. Treaty shopping is notillegal:

Overall, countries need to take, and do take, a holistic view. Thedeveloping countries allow treaty shopping to encourage capitaland technology inflows, which developed countries are keen toprovide to them. The loss of tax revenues could be insignificantcompared to the other non-tax benefits to their economy. Many ofthem do not appear to be too concerned unless the revenue losses

3 9 Union of India v. Azadi Bachao Andolan, (2003) 263 ITR 706 (Supreme Court ofIndia).




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are significant compared to the other tax and non-tax benefits fromthe treaty, or the treaty shopping leads to other tax abuses. Whetherit should continue, and if so, for how long, is a matter which is bestleft to the discretion of the executive as it is dependent upon severaleconomic and political considerations.

B. Tax Avoidance Technique #2 – Controlled Foreign Corporation40

Foreign-sourced income is taxed after it is accrued as income in the countryof residence of the recipient; thus it becomes possible to defer (or avoid) tax onforeign dividend income until it is repatriated (for example, by not declaringdividends or receiving them in an entity located in a “tax haven”). Severalcountries prevent their residents from accumulating funds abroad throughexchange control restrictions. As countries increasingly ease their exchangecontrol rules many of them have enacted Controlled Foreign Corporation[hereinafter “CFC”] rules to ensure there is no deferral of taxes on the foreignincome.

Under the CFC rules, the domestic law effectively extends the residence taxrules to the income. It requires that the tax due on foreign profits, whetherdistributed or not, be paid currently at home by tax residents.

CFC rules are normally applied in cases where the resident shareholders,individually or collectively, have substantial influence or control over a foreigncorporation. Note that the said control could be equity or voting or ability toshare profit or assets on liquidation or nominative (de facto) control. The level ofcontrol requirement (i.e., the “control test”) by resident shareholders to qualifyas a CFC varies widely.

For example:41

a) More than 50% equity or voting rights (i.e., control)

- All resident shareholders: Germany, Israel, Japan, Portugal, SouthAfrica, U.K.

- Five or fewer resident shareholders: Canada, United States

- Single resident shareholder: Brazil, Denmark, Italy, Lithuania

4 0 Supra note 7, at 184-189.4 1 Supra note 7, at 184-189.


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b) At least 50% (i.e., substantial influence)

- All resident shareholders – Finland, Norway, Sweden, Turkey

- Five or fewer resident shareholders – Australia, New Zealand

- Single resident shareholder – France, Israel, Korea, Spain

c) Less than 50% but one resident shareholder has significant influence

- Single resident shareholder – 40% or more share ownership inAustralia and New Zealand; 25% or more equity in Denmark,Portugal and Sweden; and at least 5% equity with minimuminvestment of 50% equity control through a corporate group in France.

d) Countries which do not have any CFC legislation

- India, Austria, Belgium, Iceland, Ireland, Greece, Luxembourg,Netherlands, Poland, Switzerland.

An important question must be answered: what transactions are taxableunder these CFC rules? Not all transactions are subject to CFC rules, they onlyapply to the attributable income of the controlled foreign corporation. Countriestake different approaches for arriving at the attributable income:

i) Locational/designated jurisdictional approach

- Countries may be defined under a “white list” or “black list”.

- Several countries compare the effective foreign tax rate with their owneffective rate, as computed on similar income under tax principles. CFCrules then apply to countries that have an effective rate equal or belowminimum specified rate.

ii) Transactional approach

- Targets “tainted” income; usually passive income and specific active income.

- Such tainted income is attributed to domestic shareholders, subject toexemptions (Examples: United States, Canada).

C. Tax Avoidance Technique #3 – Thin Capitalization

Debt financing of cross-border transactions is often (not always) favourablethan equity financing for taxpayer.42 In certain cases, dividend receipts may be

4 2 Supra note 7, at 214-237.




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preferable to interest income; for example if the dividends are tax exempted andinterest received is subject to a relatively high tax rate in the state of residence.Thin Capitalization refers to excessive use of debt over equity capital; this can bevia hidden equity capitalization through excessive loans (or) the artificial use ofinterest-bearing debt instead of equity by shareholders with the sole or primarymotive to benefit from tax advantages.

Some countries have thin capitalization rules which are primarily concernedwith loan capital provided by non-resident lenders, who are also substantialshareholders of a domestic company. As expected, these rules vary widely incounties that do apply the thin capitalization rules.

At the basis of thin capitalization is the use of debt instead of equity; normallysuch use of debt instead of equity has several tax and non-tax advantages. Forexample:

- Interest expense is tax-deductible whereas dividend payments are not

- Unlike interest, dividends are usually subject to economic double taxation

- Debt financing avoids wealth taxes, net worth taxes and other capital dutiesimposed on equity contributions

- Debt allows the repatriation of capital invested as loan repayment withouttax consequences

- It is possible to select currency of debt to minimize foreign exchange risks;equity is normally denominated in the currency of the host country

- Debt provides greater flexibility since it is possible to convert debt to equitybut not the reverse

- Withholding tax on interest is often nil or lower than on dividends.

Approaches to thin capitalization taken by countries worldwide can becategorized as follows:43

i) Arms-Length approach: Based on general principle of thin capitalisation;would an unrelated party provide debt funds on same basis as relatedparty loan arrangement?

4 3 Supra note 7, at 214-237.


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ii) Hidden Profit distribution: Specific provisions under tax law allow loaninterest to be reclassified as “constructive dividend”; these apply usuallywhen lender and borrow are related persons or have defined relationship.It may also apply if subsidiary company is undercapitalized and a loanfrom parent is of a permanent nature or on non arm’s-length basis.

iii) “No rules” approach: No specific rules; use GAAR and judicial doctrines

iv) Fixed Ratio approach: Specify maximum debt-equity ratio in the rules

It must be noted that rules under domestic law on international thincapitalization may be limited or overridden by double tax treaties. Also, manycountries, as yet, do not have any thin capitalization rules; examples are India,Finland, Iceland, Ireland, Sweden, Israel, Indonesia, Brazil, Singapore, etc.

D. Tax Avoidance Technique #4 – Transfer Pricing Manipulation

Transfer pricing is an economic term which refers to valuation process fortransactions between related entities. The real issue is the sharing of taxableincome by countries in which the MNEs operate lawfully.

Transfer pricing affects situations when goods and services are provided,knowingly or otherwise, on a non arm’s-length basis by related entities.

Let us consider an example where transfer pricing manipulation can occur:suppose a corporation manufactures products in country A and sells the finishedproducts in country B (via its subsidiary S) to unrelated parties (say, the public atlarge). In such a case S’s taxable profit is determined by three factors:

a) price at which it resells products to the unrelated parties

b) price at which the products were obtained from its parent corporation

c) its expenses other than cost of goods sold.

Now if country A, where the products are manufactured, has a tax ratemuch lower than B’s tax rate where the products are sold to unrelated parties,then the corporation would try to book as much profit as possible in country Aand towards this show a very low sale value of products to country B. If the taxrate were higher in A than in B then the corporation would show a very high salevalue and concentrate almost the entire profit in the hands of the manufacturer(country A). This is a clear example of when associated enterprises deal with eachother, their financial relations may not be directly affected by market forces butother considerations.




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Towards such transfer pricing issues, the arm’s length principle (Article 9,OECD MC) has been evolved; it seeks to determine whether the transactionsbetween related taxpayers (in this case the corporation and its subsidiary S)reflect their true tax liability by comparing them to similar transactions betweenunrelated taxpayers at arm’s length.

Arriving at the appropriate arm’s length price is done through a plethora oftransfer pricing methods, which usually prove to be a point of contention betweenthe taxpayers and the revenue.

It must be noted that there are many transactions which may involve suchtransfer pricing issues:44

- Transfer pricing of tangible property. For example, sale and purchase ofinventory and other physical assets.

- Transfer of machinery, rental of property & leasing arrangements. Forexample, re-invoicing or “turnaround” companies.

- Transfer pricing of intangible property rights. For example, manufacturing/trade & marketing intangibles.

- Provision of services. For example, provision of technical services with orwithout transfer of an intangible right. Management assistance andservices, sharing of overhead costs.

- Provision of finance. For example, interest rate, amount, guarantee orcollaterals on related party debt; short-term working capital financethrough inter-company transactions; market penetration or maintenancepayments through reduction in TP; credit terms and financingarrangements including deferred payment arrangements or factoring ofinter-company debts.

Countries typically tend to limit their transfer pricing rules to cross-borderrelated transactions only; however several of them include similar domestictransactions as well. Some examples are Canada, Belgium, Denmark, Greece,Poland, Portugal, Slovenia, United Kingdom, and United States.

Furthermore, as noted above, countries typically apply transfer pricingrules to certain related party transactions. However, some countries use a broaderdefinition of “associated enterprises” based on mutual benefit or influence like

4 4 Supra note 7, at 239-274.


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India, China and Korea. Few countries include transactions with preferential taxregimes and tax havens under transfer pricing rules like Argentina, Brazil, Latviaand Turkey. Many countries still do not have specific transfer pricing rules intheir domestic tax law and rely on other anti-avoidance rules, if they exist.

There are countries which have safe-harbour rules under which they grantpartial or total relief from transfer pricing obligations. For example, in Brazil theagreed minimum percentage mark-ups based on industry norms may be used inspecific transactions.

Many countries have established procedures to grant transfer pricing rulingsunder an “advance pricing arrangement” (APA). These APAs provide for certaintyfor the taxpayer on the taxation of certain cross-border transactions. Thesearrangements may be bilateral or multilateral. A major issue with transferpricing rules is that of contemporaneous documentation. Countries which adoptthe OECD Guidelines usually enforce the rules through the requirements that thetaxpayer maintain and provide such documentation to support the compliancewith them under their domestic tax law. Non-compliance with documentationrules which are usually subject to external review (say, by accountants) may faceheavy penalties. This documentation is a major issue because of the enormousoverhead cost it creates for the multinational taxpayer.

E. Tax avoidance Technique #5 – Transfer of Residence45

Certain countries regard a transfer of residence as a form of tax avoidance.In jurisdictions with worldwide tax regime, taxpayers when they become non-residents are no longer liable to pay taxes on their foreign source income. Moreover,the gains on movable property accrued during period of residence but realized attime of departure also escape taxation. Such countries have enacted SAARs toprevent tax avoidance through emigration. Examples are Australia, Canada,Denmark, U.S.A., etc.

Regarding Transfer of Corporate Residence, the transfer may requirecompany to be wound up or deemed as liquidated in several civil law jurisdictions(Example: Australia, Belgium, Denmark, Sweden). If a German company transfersits head office abroad, the law will dissolve it; a foreign company cannot transferits registered office to Germany. Certain countries choose to impose an “exit tax”46

when company ceases to be their resident - the company in such a case is subject toa capital gain on its deemed sale. Examples include United States, UK, Canada andAustria.




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F. Tax avoidance Technique #6 – Branch Entities

Under a classical tax system, host country taxes the corporate profits twice– at company level and again when company pays dividend. Most countries donot tax remittances of after-tax branch profits to non-residents. A branch entitytherefore avoids this economic double taxation.47

Several jurisdictions regard the use of a branch as an unjustified loss of taxrevenue that would have been due to them as dividend withholding taxes from asubsidiary. Thus, an additional tax either on branch profits or on remittances tohead office is levied.

G. Tax avoidance Technique #7 – Tax Havens

Tax havens are jurisdictions which tend to have nil or low taxation. Taxhavens may also be jurisdictions which have other benefits like financial secrecy,minimum reporting requirements, ring fencing, discretionary tax privileges,allowing ownership to be held in trust, no registry of companies and partnerships,no taxes on dividends and interest payments to non-residents, etc.

Some examples48 of Tax havens are:

- Zero-tax jurisdictions: Panama, Cayman Islands, Bahamas, etc.

- Low-tax jurisdictions: Guernsey, Jersey, Bermuda, Isle of Man, etc.

- Captive insurance: Bermuda, Barbados, Madeira, Labuan, Ireland, etc.

- Offshore banking: Cayman Islands, Switzerland, Luxembourg, Jersey, etc.

- Collective investment schemes: Hong Kong, Cayman Islands, Switzerland,Luxembourg, Bermuda, Guernsey, Jersey, Dublin (Ireland), etc.

- International Shipping: Liberia, Panama, Malta, Isle of Man, Gibraltar, etc.

Several countries have SAARs, i.e., specific anti-avoidance legislation tolimit the deductions of tax expense or grant of tax benefits to entities located incertain blacklisted countries.

4 5 Supra note 7, at 278-290.4 6 Supra note 7, at 278-290.4 7 Supra note 7, at 278-290.4 8 Supra note 7, at 291.


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V. INTERESTING LEGAL QUESTIONS RELATED TO

ANTI-AVOIDANCE

There are several interesting legal questions related to the interplay ofdomestic laws and treaties (DTAAs).

Q1) Where do the treaties stand with respect to domestic tax avoidancemeasures passed by countries?

Do the relevant domestic rules

- complement tax treaties?

- do they limit the application of treaties?

- are they limited by tax treaties?

- are they designed to circumvent limitations in treaties?

After the changes in 2003, Article 1 of the OECD Commentary concludesthat domestic law anti-abuse rules do not conflict with treaties though Portugalhas expressed strong reservation to this conclusion.

As usual, countries follow differing policies with respect to resolving theconflict between treaties and domestic anti-avoidance provisions. The Indianview currently is that tax treaties override domestic anti-avoidance rules. USAand Germany try to reconcile domestic provisions with treaties but treatyoverride does occur; the USA follows a “later in-time rule” for conflict resolution.

It is our view that most domestic rules & treaties can indeed be reconciledon most issues like base companies, transfer of residence, base erosion andcharacter of income. However one cannot give a blanket statement because somedomestic rules may exist on thorny issues which cannot to be reconciled easilywith treaties. Good examples are:

- Re-characterization of debt that exceeds the debt-equity ratio into equity

- Limitation of application of thin capitalization rules to debt from non-resident taxpayers

Many experts feel that in the future, with the strong push for anti-avoidance,we might see a lot more cases being decided where the Courts hold the double taxtreaty irrelevant.




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Let’s take the Aznavour case49 for example. In this case, Charles Aznavour,the French singer was a resident in Switzerland and performed in France througha company established in U.K. Under French domestic law the income chargedby the company was attributable to Aznavour and taxable to him. The Counseild’ Etat determined that the income tax treaty with U.K. was not applicable, becauseunder French law the UK company was not regarded as a taxpayer with respectto the income and because the income was attributable to a resident ofSwitzerland, the treaty between France and Switzerland was applied and thatTreaty did allow France to tax the income.

Q2) Is the abuse of tax treaty addressed by domestic law principles or by theinterpretation of the tax treaty?

Countries as usual, respond differently to this question:

- Belgium believes abuse of treaty cannot be addressed without a domesticGAAR

- India, Finland, New Zealand etc. believe that abuse must be treated byinterpretation of the treaty and they stress on following the ViennaConvention on the Law of Treaties (Article 31).

Some interesting case laws deserve mention in this regard:

a) MIL Investments case – Canada50

The company, MIL Investments, was resident in Cayman Islands and itowned more than 10% of Diamond Field Resources Ltd. (DFR), a companyresident in Canada. MIL entered into several transactions; in a tax-freetransaction it exchanged a number of DFR shares with result that its interestdecreased to less than 10% of DFR. Subsequently, MIL incorporated inLuxembourg & became resident there. MIL then sold some of the shares ithad received in exchange for DFR shares and later it disposed of its entireinterest in DFR, realizing a significant capital gain. The key point was thatthe capital gains were taxable under Canadian domestic law but if MILcould successfully invoke the protection of Article 13 of the Canada-Luxembourg DTAA, the gain would be exempt from taxation in Canada.Revenue Canada tried to argue that the Treaty is inapplicable. However,

4 9 French Supreme Administrative Court, Mar 28, 2008, No 271366, 9th & 10th Section,Aznavour.

5 0 MIL (Investments) S.A. v. The Queen, [2006] 5 C.T.C. 2552 (Can.) (Tax Court ofCanada) (affirmed on other grounds, 2007 FCA 236).


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though the Canadian Court was receptive to GAAR, it ruled in favour ofMIL. Interestingly, Court tested the transaction against Canadian domesticGAAR, i.e., treaty abuse was addressed by application of domestic rules.

b) Yanko-Weiss – Israel 51

Yanko-Weiss (Y-W), a company resident in Israel owned shares in asubsidiary that was also resident in Israel. In 1999, Y-W moved its effectivemanagement to Belgium and became a resident under Belgium tax law. Inthe following it received a dividend from the Israeli subsidiary and claimedreduced dividend withholding pursuant to the Belgium-Israel tax treaty.Israeli Revenue refused saying that the no economic purpose of residence inBelgium and emigration to Belgium should be treated as a sham. The IsraeliCourt confirmed that the Treaty benefits can indeed be denied in the presenceof a sham transaction. The Israeli tax authorities took a view that domesticanti-avoidance rules are in line with the income tax treaty and hence treatyabuse can be addressed by application of domestic GAAR itself.

c) “A Holding” case – Switzerland 52

In this case, “A Holding ApS” a company resident in Guernsey hadinterposed a Danish holding company - “A Holding”, in order to own sharesin a company resident in Switzerland. “A Holding” was a mere holdingcompany without any economic activity and had been organized with aview to obtain benefits of the Denmark-Switzerland Treaty only. “A Holding”received a dividend from its Swiss subsidiary and invoked the benefits ofArticle 10 of the Denmark-Switzerland tax treaty. Swiss authorities deniedbenefit of the Treaty arguing that “A Holding” had only been organizedwith a view to obtaining Treaty benefits and granting such benefits wouldbe abuse of the tax treaty. Court referred to the principle of abuse of rightsin Denmark and denied “A Holding” benefits of the Treaty. Here again, treatyabuse was dealt with by domestic law principles.

d) Azadi Bachao Andolan – India 53

In this case, the lower tax authorities denied DTAA benefits to certainMauritius resident companies investing in India. CBDT had clarified in

5 1 District Court decision 005663/07 Yanko-Weiss Holdings v. Holon Tax AssessmentOfficer dated Dec. 30, 2007.

5 2 “A Holding” ApS v. Federal Tax Administration, (2005) 8 I.T.L.R. 536 (Swiss FederalCourt).

5 3 Union of India v. Azadi Bachao Andolan, (2003) 263 ITR 706 (Supreme Court of India).




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Circular 789 that Mauritius certificate of residence is sufficient for claimingtreaty benefits. The Supreme Court upheld the validity of Circular and theIndia-Mauritius Tax Treaty. It said that ‘treaty shopping’ per se is not illegal;specific safeguards may be in the treaty itself. The Supreme Court rejectedthe submission that an act which is otherwise valid in law can be treatedas non est merely on the basis of some underlying motive supposedlyresulting some economic detriment to the national interests, as perceivedby Revenue. It also says that rule in McDowell cannot be read as layingdown every attempt at tax planning is illegitimate.

Roy Saunders54 asks even more fundamental & probing questions

- “Can we rely on double tax treaty provisions anymore?”

- “Are the taxes of just one country being avoided or in fact is double taxationbeing avoided?”

This discussion throws up many points to ponder. Treaties are “living”documents. Their interpretation has evolved over time. Substance has graduallybecome more important than form, especially as more complex tax avoidanceschemes are evolved and newer financial instruments and technologicalinnovations come about. It is clear that when push comes to shove, individualgovernments would want to collect tax from large cross-border transactions. Insuch a scenario, interplay & friction between treaty and domestic anti-avoidanceprovisions is inevitable.

VI. INDIA’S DTC: PROPOSED GAAR

The Indian government is set to introduce the Direct Tax Code [hereinafter“DTC”] in the coming year(s). The DTC 55 brings a number of changes to theexisting Income Tax Act, 1961; we are chiefly concerned with the provisions ofGAAR found in the DTC. According to the DTC:

The Commissioner is empowered to declare an arrangement as animpermissible avoidance arrangement (IAA) if:

5 4 Roy Saunders, New Developments: Recent Changes Affecting International Tax Planning,ITPA Zurich, June 2009.

5 5 Ministry of Finance, Direct Taxes Code, available at http://finmin.nic.in/dtcode/index.html.


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- The whole, a step or a part of the arrangement has been entered with theobjective of obtaining tax benefit, and the arrangement:

• Creates rights and obligations not normally created in arm’s lengthtransactions, or

• Results in direct or indirect misuse or abuse of the provisions of thecode, or

• Lacks commercial substance in whole or part, or

• Is not bona fide.

Once treated as an IAA, look through is permitted by:

- Disregarding whole or part of the impermissible avoidance arrangement

- Treating related or accommodating or connected parties as one and thesame person

- Reallocating amongst parties or re-characterizing any accrual, receipt,expense, deduction, rebate etc. whether revenue or capital

- Re-characterizing debt or equity or vice versa.

Furthermore, a transaction “lacking commercial substance” is defined toinclude situations where there is:

- Significant tax benefits without a significant effect upon business risk ornet cash flows

- Legal substance or effect differs from legal form

- It involves or includes:

• Round trip financing

• An accommodating or tax indifferent party

• Any element that has the effect of offsetting or cancelling each other

• A transaction which is conducted through one or more persons anddisguises the nature, location, source, ownership or control of funds.

The GAAR can be invoked as an alternative to or in addition to any otherbasis of making an assessment. There is a presumption of purpose – the onus ofproving that the purpose of transaction is not to avoid taxes is on the assessee.




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Presumption applies even if main/overall purpose of arrangement is not to obtaina tax benefit and only if a step/part of the arrangement is to obtain a benefit.

Clearly, these rules offer a significantly wide scope to the Revenue; here aresome points to ponder if this GAAR comes into law:

a) Are these appealable orders? Will there be dispute resolution?

b) Will Advance ruling (AAR) be given on such transactions?

c) What are the penalties involved?

d) Does this mean transfer pricing rule for all transactions (even domestic)?

e) Thin-capitalization rules – what is the impact of currency law?

f) No safe-harbours and/or guidance on threshold debt-equity ratios areprovided

An interesting comment was made recently that the Indian GAAR seems tohave been completely ‘derived’ from the recent South African GAAR. It is soclosely ‘derived’ that in the South African GAAR, the Commissioner is empoweredto pursue GAAR issues and the Indian GAAR seems to have the same wordingthough the Commissioner in South Africa is equivalent to the highest office of theCBDT here and is at a wholly different and higher position than the IndianCommissioner! If anything, the South African GAAR process of public debate &comments followed up by feedback with detailed analysis and findings beforepassage into law should be followed.

VII. INDIAN ANTI-AVOIDANCE & THE VODAFONE CASE

A. Why study the Vodafone case?

The highly publicized Vodafone56 case is pending before the Courts as thisarticle is being written. Hence we will merely delve into the facts of the case asknown to us. The reason this case is of importance to an anti-avoidance discussionis that experts feel the outcome of this case may throw light on how the proposedGAAR will be pursued/interpreted in the coming years. Will substance overform prevail? Will piercing the corporate veil going to be common moving

5 6 Vodafone International Holdings BV v. Union of India, (2008) 175 Taxmann 399(Bom.) (High Court of Bombay).


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forward? Do Azadi Bachao and Vodafone signal a generational shift? These are someof the questions this case raises at a broad level. In this paper we will simplyexamine the facts of the case and let the reader come to his/her own conclusions.

B. Background of Vodafone case

Vodafone acquired 66% interest of Hutchison (Hong Kong) in Hutch-Essar’s(an Indian company) shares for USD 11 billion held by its Cayman holding companythrough its Dutch subsidiary. The Indian Revenue sent a “show cause” notice toVodafone-Essar in India why the capital gains tax of around USD 1.7 billion shouldnot be payable by them as underlying business and assets are based in India.Section 201 in the I.T. Act, 1961 has been amended in May 2008 retrospectively tomake the foreign buyer liable to withhold Indian tax in such cases.

C. Overview of the Vodafone case & issues raised by the Revenue:

Figure 5: Overview of the Vodafone case

Issues raised by the department were:

- Indirect transfer of shares of Hutch-Essar (India) by Hutch International(Hong Kong).

- Allegation by Tax Department that Hutch International is liable to tax inIndia

- Vodafone-Essar (new Indian entity) is an agent of Hutch International, andhence liable to tax in India as ‘representative assessee’.




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- Tax authorities are assessing 400 plus similar cases. (Retrospective amendmentbackdated to 2002 made to tax withholding section by Budget 2008).

- Vodafone has challenged the notice and the amendment in Bombay HighCourt.

D. Legal process overview & current status

Figure 6: Legal process overview of Vodafone case

E. Facts of the Vodafone case

- Hutchison Telecommunications International invited bids from severalinvestors for auctioning its investments in a Cayman Island Company.

- Indian Income Tax authorities sought requisite information from Vodafonewith regard to the purchase of shares, by its group company based atNetherlands, of this Cayman Island Company owned by Hutchison, HongKong.

- The Cayman Island Company owned shares of a Mauritian Company whichhad invested into the shares of an Indian telecom company.

- Vodafone challenged this action of Indian tax authorities and sought toobtain injunction over the said action by filing a writ petition with BombayHigh court.


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F. Legal issues being debated

Income Tax Department & Vodafone sparring on the following legal issues

- Scope of Indian Income Tax Act over non-resident

- Section 201 (assessee in default) retrospective amendment

- “Transfer of a capital asset”

- Show-cause notice issues

- Territorial jurisdiction of Indian tax laws & authorities

G. Bombay High Court ruling

In the Bombay High Court, the tax authorities made a strong prima faciecase that:

• The transaction was one of transfer of capital asset situated in India,

• It would be too simplistic to hold that Vodafone merely acquired the sharesof an unknown Cayman Island Company, and

• The purpose of acquiring shares in the Cayman Island Company was toacquire controlling interest in the Indian Company and hence there seemsto be transfer of capital asset situated in India.

Furthermore, the ‘effects doctrine’ has been approved and relied upon bythe Supreme Court of India. Vodafone has not been able to demonstrate that theSCN is non est in the eyes of law for absolute want of the jurisdiction of theauthorities. Also, Vodafone has failed to produce the relevant agreement/document without which it is impossible to appreciate the true nature of thetransaction. It must also be noted that Vodafone’s interests are fully safeguardedby section 195 or 197 of the Income Tax Act. The Bombay High Court in light of allthese facts dismissed the writ petition with costs to the tax authorities.

H. Supreme Court – Special Leave Petition

The Supreme Court dismissed the Special Leave Petition filed. The SupremeCourt asked Vodafone to go back to the income tax department and file all relevantdocuments so that they can decide whether they have jurisdiction or not to servenotice on Vodafone.

The decision is thus open and pending.




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I. Conclusion

Is this the precursor to Indian Revenue’s anti-avoidance approach? FromAzadi Bachao to Vodafone – is this an anti-avoidance zeitgeist? It is felt that whenpush comes to shove, Indian revenue authorities are not going to let treaty or anystrict doctrines come in the way of tax collection. We are of the view that substanceshould be considered over form if it is concluded that there is indeed tax avoidanceafter genuine investigation of the transactions.

VIII. CONCLUSION

We have seen from our detailed tour of the world of tax avoidance and itscounter measures that tax avoidance is a complex and evolving game and to counterthis we can see that there are a plethora of techniques practiced by governmentsaround the world ranging from judicial doctrines, SAAR and GAAR andadministrative measures.

It seems to one that various countries are trying to constantly play catch-upwith the evolving tax avoidance techniques in a never-ending cat & mouse game.

Coming to the proposed Indian GAAR in the DTC, it is an expected, butnevertheless significant step. The opening up of our economy, our high growthrate, the tremendous growth of foreign interest in Indian shores, the huge cross-border transactions and flows and the growth of our “intangible” economy hasopened up a gift box for the investor but a Pandora’s box as far as the Revenue isconcerned, with aggressive tax planning and structuring being the order of theday. The Indian Revenue no doubt feels there is a huge loss to the Revenue due tothe practice of various tax avoidance techniques and a GAAR is needed to cast awide net in order to prevent to bring tax avoiders under their scanner.

The key issue is not so much that India is evolving a GAAR but more so theunfortunately frightening certainty of there being uncertainty andunpredictability for the taxpayers in the GAAR implementation by the IndianRevenue authorities. After all, the devil is in the details when it comes to GAARdue to its sweeping reach.

The unanswered questions on the back of everyone’s mind are no doubt:

a) Whether GAAR will be (mis)used as a catch-all mechanism by the IndianRevenue authorities. The past and current behaviour of the Revenueauthorities will probably lead to sleepless nights for the taxpayer once theGAAR provisions are in place!


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b) How will the Indian Courts interpret the GAAR provisions? Historicallythey have been favourable to tax payer when it comes to things like treatyshopping (Azadi Bachao Andolan). But will there be a seismic shift?

An even more fundamental question is whether India really needs a GAARand why the current system of a combination of judicial rulings and SAARs willnot suffice? We hope that the Indian DTC GAAR is not a case of “calm before thestorm”.

IX. ACKNOWLEDGEMENTS

An excellent source of reference is Roy Rohatgi’s Basic International Taxation(Volume I & II);57 important material for this paper was obtained from this source.Various other sources, including the Internet, played an important role incompiling this paper. References to all the sources are provided wherever possible;any omission or mistakes in them are to be kindly treated as genuine errors andnot construed otherwise.

Furthermore, taxation, especially international taxation, is evolving at avery fast rate. By no means should this paper be used as a source of taxationadvice and/or as a substitute for professional advice and research.

We wish to thank the National Law School, Bangalore and its excellentstudents & faculty, especially Mihir Naniwadekar, for giving us an opportunityto present and publish this paper.

57 Supra note 7.



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